Conceptual Framework

The basis of using money as either an information or intermediate variable is that there is some reliable relationship between the movements in money and prices. However, movements in prices may result from movements in other variables that may contain more information about prices than does money.

Typically, many central banks collect and analyse a number of indicators.

Emphasis placed upon one particular indicator to the exclusion of other indicators implies that the monetary authority believes that the particular indicator is the most important for movements in inflation and other variables do not add any valuable information to the information set.

If we consider a small open economy, we see that factors that affect both aggregate supply and aggregate demand would affect the price level. For example, on the one hand increases in money supply, changes in money demand and increases in government expenditure, which increase aggregate demand, will cause an increase in prices. On the other hand, supply side

factors such as technology shocks, changes in capacity utilisation resulting from restructuring, exchange rates and productivity can also lead to price changes. With high import dependency, foreign prices can also have a very significant effect on domestic prices.

The financial programming framework used to implement monetary policy in Zambia and many other African countries under Structural Adjustment Program (SAP) however emphasises the role of the growth of money supply.

The reason for this focus is mainly due to the assumption that only growth in money supply leads to persistent increases in inflation (Romer (1996)). This assumption rests on the premise that the equation of exchange holds in some form. Consider the income version of the equation of exchange shown below.

M V ≡P Y (3.1)

Where M is money supply, V velocity, P a price index and Y is real output.

Under classical assumptions, V is assumed to be constant or fixed and Y at full employment. Expressed in logs, the equation becomes

m+v≡p+y (3.2)

Under classical assumptions, changes in money balances translate directly into changes into prices i.e ∆m≡∆pconditional on ∆yand a stable money velocity. In reality, output is rarely at full employment especially in developing countries. There are structural rigidities in most of these economies that inhibit full capacity utilisation of resources and thereby immediate adjustment.

The key to this relationship between money and prices is money demand which links money to prices, interest rates and output through spending and saving decisions which individuals make. The amount that is held either as balances or as deposits depends on amongst other things, the levels of interest rates, prices, innovations in the banking sector and general economic activity.

Velocity (the frequency at which individuals conduct their transactions) depends largely on levels of income, changes in prices and innovations in the

payments system. We have said above that for the supposed relationship to hold, velocity must be relatively stable. When this is the case, and money grows faster than output, prices will increase and if money grows very rapidly, then we have an inflationary situation.

When money demand is unstable, controlling inflation using money supply becomes very difficult. Factors such as changes in financial regulations, financial innovations, and changes in portfolio preferences can lead to

instability of money demand. This is very likely to have happened in Zambia since the reforms.¹ A lot of controls that were in place in the financial markets were removed in the early 1990’s and with increased competition, there has been a lot of innovation especially in the banking sector. The introduction of interest earning checking accounts, plastic money and increased access to consumption loans could very well have changed money demand in the country.

In addition to money supply, other financial variables are monitored by central banks. This is necessary because policy is forward looking and monetary policy works with a lag. Since output and inflation are often difficult to measure at short frequencies, policy makers often have to rely on many indicators that are closely related to the policy goals. We briefly discuss some of the variables we think are necessary to the Zambian situation below.

3.3.1 Interest Rates

Many central banks conduct monetary policy by setting or targeting

short-term interest rates. Increases in interest rates usually signal tightening monetary policy and should slow down inflationary pressures. Once these rates are set, the market mechanisms then work to determine the detailed structure of the lending and deposit rates. For this to work, an efficient monetary transmission mechanism is required. However, interest rates are not always a clear indication of the stance of monetary policy as they contain information

1We note here that Adam (1999) finds a stable money demand in Zambia with a portfolio shift. However, a lot of changes have been implemented since 1996 especially with respect to the payments system, bank regulation and innovation.

about both the interest rate and expected inflation.

Due to some of the changes occurring as discussed above, these mechanisms may not work very well in a developing country like Zambia. One of the reasons may be changes resulting from the reforms such as the removal of interest rate controls, which may initially lead to high levels of non-performing loans, which are compounded by inadequate loan management eroded over long periods of financial repression. The lack of competition may also lead to sluggish responses of interest rates to policy changes.

3.3.2 Exchange Rates

The exchange rate can be used as an indicator of inflationary pressures. In some cases, it is also used as an intermediate target. It reflects both domestic and foreign pressures. A depreciation is associated with positive inflationary pressures and affects inflation through the ’aggregate -demand’ and the

’direct exchange rate’ channels.² When the real exchange rate rises, the domestic prices of imported and exported final goods increases. The rise in exportable goods’ prices can be either due to increases in costs of inputs arising from the depreciation or from increased demand since the depreciation makes domestic goods cheaper in foreign markets. This results in increased CPI inflation.

The effect of exchange rates however may be transitory. Factors such as the degree of openness, domestic capacity utilisation and changes in policy may also affect the degree of effect exchange rates may have on inflation (Kozicki (2000)). For example, if the country has capital controls, the effect of

exchange rates on inflation may not be as large as when the capital account is open since the effect of capital movements (such as predicted by interest parity) will be absent. However, in some cases, the exchange rate can have long term effects on inflation. In countries such as Zambia, which had an overvalued exchange rate for a long time before the reforms and which are still

2See Svensson (2002)

heavily import dependent, there is likely to be persistent exchange rate effects on inflation after the liberalisation of the exchange rate.